Precautionary Saving and Consumption Fluctuations

Abstract

This paper uses the consumption Euler equation to derive a decomposition of consumption growth into four sources. These are new information and three sources of predictable consumption growth: intertemporal substitution, changes in the preferences for consumption, and incomplete markets for consumption in- surance. Using data on the expenditures of households, we implement the decom- position for the average growth rate of consumption expenditures on nondurable goods in the U.S. from the beginning of 1982 to the end of 1997. Incomplete markets for trading consumption in future states lead to statistically signiÞcant and countercyclical movements in expected consumption growth: consumption growth is expected to be higher when the unemployment rate is high. The eco- nomic importance of precautionary saving rivals that of the real interest rate, but the relative importance of each source of movement in the volatility of consump- tion is not precisely measured.